What is a Flexible Spending Account (FSA)?
A flexible spending account (FSA) is a bank account used for spending on health care.
FSA accounts are an attractive alternative to paying for medical costs out of pocket because they are tax-advantaged.
To open an FSA account, you need to be enrolled in an employer-sponsored health care plan that offers FSA accounts. Only employees of a sponsoring employer can open an FSA; if you are self-employed, you can open a medical savings account.
There are two types of FSA accounts: the health care FSA account and the dependent care FSA account.
Both accounts have similar funding rules—the difference is in who they can be used for. The dependent care FSA can be used to care for dependents, such as elderly family members and children up to the age of 13.
Unlike the standard health care FSA account, the dependent care FSA account can be used on eligible dependent care expenses such as preschool, after-school programs, child day care, elder day care, and more.
How a Flexible Spending Account Works
When you open an FSA account, you receive a debit card and contribute money to the account from your paycheck.
The amount of money contributed to the account is set by the employee through their employer. This contribution is typically set only once a year during the annual benefits enrollment period.
There is a tax benefit associated with contributions made to an FSA account.
Money contributed to the account is pre-tax income, which means it skips income taxes.
For example, if an employee has total compensation of $50,000 and they contribute $5,000 to an FSA account, the $5,000 proceeds directly to the FSA account without facing income taxes.
In this example, the employee’s taxable income is reduced from $50,000 to $45,000.
There are several limitations to the FSA account.
A major drawback is that at the end of each year, any money sitting in the account that is not spent is lost. Also, the FSA account can only be spent on qualified medical expenses, which include doctor visits, prescription drugs, dental, and vision.
If you use the FSA account improperly for nonqualified expenses, you will be subject to a penalty which includes paying the standard income taxes on that money plus an additional 20 percent tax penalty.
Finally, FSA accounts are subject to a contribution limit. In 2019, you could contribute up to $2,700 per year to an FSA account. The contribution limit is adjusted annually by the IRS.
Flexible Spending Accounts vs. Health Savings Accounts
Flexible spending accounts are commonly compared to health savings accounts (HSAs), which serve a similar purpose but work differently.
The biggest difference between the two is that with an HSA you can keep any unspent contributions made to the account and can even invest those funds in financial assets.
Conversely, FSA account funds are on a “use it or lose it” basis—any unspent money is lost at the end of each calendar year. The table below summarizes the key differences between the two accounts.